Build or burn?

Is there a more slippery industry than savings and investment? Like estate agents, fees are based on %’s, meaning providers earn more in a rising market without having to work harder, and in a falling market they keep earning while their customers lose money. The industry has a history of selling duds such as endowment mortgages and ‘with profits’ pensions. You only know whether you have bought a good or a bad product after the event. Fee structures are opaque and you can find yourself paying an ‘active’ management fee for a fund that does little more than track the market. Layers of middle-men sit between you and your investments. Knowledge of the tax system is needed to fully understand different products. Then in 2007 we learned that even putting money in a bank isn’t safe any more. You’d be forgiven for thinking yourself better off putting your cash under a mattress.

While many of these punches hit their target, the analysis is not fair. The savings and investment industry is quite young. Tax efficient pensions savings plans were only introduced in the UK in 1988 (1980 for the US equivalent, a 401(k) plan). This turned out to be the start of an astonishing bull run in stocks and shares. At that time, companies were still making open-ended commitments to pay a percentage of employees’ final salaries as pensions, increasing with inflation after they retire and providing benefits to surviving spouses. The maths of these commitments means company pension funds need about £25,000 saved for every £1,000 of promised income. The good financial times obscured the true costs of these guarantees even while they became more expensive because people live longer. Even so, after two hard crashes, stock market assumptions are more chastened, regulators are belatedly looking at fees, and any problems missed by these developments the internet will no doubt sort out eventually.

I’m prepared to forgive these growing pains of the savings and investment industry because a sober and mature savings and investment market cannot come quickly enough. The government cannot afford to keep us in our old age and we citizens don’t have enough saved to fill the gap. We need to save more, and more of our savings need to be invested in the stock market. But a lot has to change before this new equilibrium can be achieved.

The best financial advice I ever received was to save more. I learned this lesson while dithering over whether to increase a small monthly pension by a few pounds. My financial advisor told me, in ways that only a Glaswegian can, that I should be putting a lot more aside. Without his directness I would have continued playing at saving rather than taking it seriously. As a consequence I increased my monthly saving by a factor of five. Even so, I left it unchanged for the next 10 years, despite my earnings increasing considerably. It was medicine I really needed to take every year.

This brings me to the first big change that needs to take place. A realistic lifetime savings target, for individuals and couples, needs to be more firmly established in the minds of citizens. The man in the street should have at least a hazy idea of how much of his household income should be saved and know the consequences (working later in life) if he – and the contribution from his employer – falls short. For the woman in the street, this knowledge is even more important because she is more likely to have gaps in her employment when she raised a family and may be financially vulnerable if she separates.

You should be saving a minimum of 15% of earnings (see tutorial: How much should I save and when can I retire?). It should be 16.5% if you want to match the benefits of some of the more modest final salary schemes. Moreover, this target is an average over your whole life earnings. All those years in your twenties when you were out enjoying yourself and all those years in your thirties, when you were raising a family, need to made up by saving more in your forties, fifties and sixties. Similarly, if there have been any gaps in your employment history, these too need to be made up by higher savings after you eventually join or rejoin the labour pool. This should be common knowledge. No doubt, no one wants to scare us, but both the industry and government need to be a little more candid with us about the new financial facts of life.

The second major culture change that has to occur is that we need to grow up when it comes to risk. It is ridiculous that when I invest in a stock market tracker fund my financial advisor is obliged to tell me that the risk profile of the investment is 8 on a scale of 10. Nonsense. If I was investing for a period of less than 5 years, yes; less than 10 years, maybe, but we’re talking about pensions here. On timescales of beyond 15 years and beyond the risk profile of a stock market tracker is 5 on a scale of 10.

A risk-averse attitude to risk harms our wealth. It is common advice to diversify your portfolio, perhaps, with 60% in stocks and shares, and the rest in bonds or property. This is not bad advice, but it is not the best advice. Your pension will be smaller if you follow it. For something like a pension, where you might be 35 years saving and a further 30 years drawing down these savings, you should be 100% invested in shares. Warren Buffet, the world’s most successful investor, describes diversification as ‘protection against ignorance. It makes little sense if you know what you are doing’. If you can handle all the ups and downs, it makes little sense to deliberately allocate some of your wealth to assets that you know will not give you the best return over the long term.

We citizens need to become slightly more financially sophisticated. At present, we only pay attention to news about shares when the headline is ‘Stock market crashes!’. Headlines such as ‘stocks rises 250% in 25 years despite recent crash’, might make more interesting reading but we first need to stop chasing a quick buck and learn to ignore excitable stories of short-term movements in the market. Over the long term, stocks are both more boring and more dependable than these headlines suggest. Whatever’s happening today, our aim is get rich slowly. This is our retirement we’re talking about, for goodness sake. Time is on our side.

The third big change that needs to take place is a structural one in the industry. At the moment, retiring citizens face a real hotch-potch of confusing, contradictory and constrained choices about what to do with their savings. It’s a mess and it badly needs tidying up. Ideally we should be completely free to do what the hell we want but, as there is a big contribution from the tax-payer and as there’s a danger we would blow the lot on fast cars, the government tells us what we must do with most of it. We must buy an annuity.

Annuities should be a good thing. Like insurance, they work by pooling the individual risks of large numbers of people for the benefit of all. Bluntly, the savings of those unlucky enough to die early help to pay a higher income than would otherwise be available had everyone else had to rely only on their own savings. Well, that is the theory.

The practice however turns out to be a lot less clear. If you live a long life, you’re quids in. But if you live a short one, your descendants lose out on an inheritance that you might otherwise wish them to have. Shouldn’t that risk be your choice to make freely rather than have it forced on you? Well, it is if you are rich enough and can prove you have enough income from other sources. What? Different rules, that doesn’t sound right.

And given the range of different annuities rates available and given the variety of our different health statuses when we retire, the suspicion is that life assurance companies, having more information than we do, are using it to make money for themselves rather than pass it on to us as higher annuities. There’s no transparency and so I have no confidence. It’s reminiscent of discredited ‘with profits’ savings products, sold by life assurance companies as it happens, where the consumer is too much in the dark.

Update: since pensions freedoms were introduced in 2015 the annuity industry has tanked.

And the final thing that needs to change is being more honest about inflation. Every illustrative forecast given about the future amount investors might expect to make on a given investment product should always be expressed in today’s money. Not as a note, or on another page somewhere, but front and centre. It won’t look very exciting, but that’s because exciting returns are only achieved if exciting sums are saved in the first place.